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Seed Weekly - Diversification - How is it a Free Lunch?

Diversification is a term in investments that is often bandied about, but typically not much thought goes into what it actually means. Phrases such as the ones below are often thrown around:

“Make sure you don’t have all your eggs in one basket.”
“Diversification is the only free lunch in investing.”
“Don’t worry I have a diversified portfolio!”
“Is your portfolio diversified or diworsified?”

Diversification is a very important concept and, when used correctly, is a powerful way to build robust portfolios. Essentially, diversification is the process of investing across a range of asset classes/investment styles/strategies that produce returns that aren’t 100% correlated with each other. In a perfect world they will have negative correlations with each other, but practically the lower the correlation the better. A consistent correlation profile is also a highly sought after trait.

To unpack the above statement I’ll more fully explain the concept of correlation and give some practical examples. Correlation ranges from -100% to 100%, where -100% is when assets move perfectly inversely to each other and 100% where they move perfectly in line with each other. The chart below shows the monthly returns of 3 hypothetical assets. As can be seen, Asset A and Asset B move broadly in line with each other and have a correlation of 66%, while it is obvious that the monthly returns of Asset A and Asset C don’t move in line with each other – here the correlation is -68%.

Over this period all 3 assets have generated a return slightly in excess of 5% with a volatility of around 9.5%. While blending Asset A and Asset B together enhances an investor’s return and reduces the risk (volatility used as a proxy for risk in this case), blending Asset A and Asset C further enhances the return and dramatically reduces the portfolio’s risk – this is shown in the chart below.

Consistent relationships are also highly sought after. In times of market stress correlations tend to rise (i.e. move closer to 100%) which puts the portfolio at risk. The last thing an investor wants when one portion of their portfolio is under stress, is for the rest of the portfolio to follow suit. It is in these times of stress that a robust portfolio (i.e. one built with assets that are truly uncorrelated) show its true colours.

You may be saying that this is all good and well when discussing theoretical concepts, but at the same time be asking whether this can be practically implemented? The chart below shows the actual return and volatility of the Seed Stable Fund as well as the return and volatility of each of the Fund’s underlying strategies (in mid-2014 – when there was a very low correlation between strategies). If all of the strategies were perfectly correlated with one another then the Fund’s volatility would have been 6%, but by carefully constructing a portfolio of uncorrelated strategies the Fund’s actual volatility was less than 3%. By diversifying properly, the Fund was therefore able to deliver to investors a “free lunch” of a 50% reduction in volatility.

Investors that seek to diversify their investments will undoubtably leave some upside potential on the table. Investors that combine a range of assets in the hope that they are diversified will find out (typically in times of market stress) that all they’ve done is ‘diworsify’ their portfolio. What investors who properly diversify will achieve, however, is robust portfolios that can stand the test of time and deliver consistent risk adjusted returns.